Client Commission Practices and Soft Dollars

January 1, 2012

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The term soft dollars describes an arrangement in which an RIA with discretionary authority receives brokerage and research services from a broker-dealer in exchange for credits generated by clients’ commissions. As we discussed in Do’s and Don’ts of Advisory Contracts, discretionary authority means that an RIA is authorized to decide which securities to buy, sell, or retain for a client’s portfolio.

According to a June 2007 posting on PLANSPONSOR.com, “Soft dollars are the investment industry’s answer to frequent-flyer miles. With mileage programs, you fly all around the country for business, rack up the miles, and can cash them in however you want. If you’re an investment manager, you can pay your brokers with commissions that are above the rates for bare-bones executions, and spend the extra ‘soft dollar’ credits on investment research, Bloomberg terminals, or other portfolio management tools.”

SEC Interpretive Release Governing Soft Dollars

On July 12, 2006, the SEC voted to publish an Interpretive Release providing guidance on RIAs’ use of client commissions to pay for brokerage and research services under the safe harbor, which is set forth in Section 28(e) of the Securities Exchange Act of 1934. The SEC’s Interpretive Release used the term, “client commission practices,” in place of the phrase, “soft dollars.” For our purposes, however, we will refer to soft dollar practices, which is the familiar term to RIAs and broker-dealers.

Securities regulators view soft dollar arrangements with skepticism because they may affect the best execution of securities transactions and cause the client to pay more than the lowest available commission. Soft dollar credits raise questions about whether an RIA has breached its fiduciary duty. Because soft dollar credits are derived from commissions paid by the advisory client, they are viewed as assets of the client.

In 1975, Congress adopted Section 28(e) of the Securities Exchange Act of 1934 (Exchange Act) protecting RIAs from charges that they breached their fiduciary duty by accepting soft dollars. Section 28(e) of the Exchange Act established a safe harbor permitting RIAs to use soft dollar credits generated from clients’ commissions to buy brokerage and research services for their managed accounts. The safe harbor is available only to persons who are exercising investment discretion as opposed to those RIAs that only have non-discretionary authority to manage a client’s account.

There are actually two safe harbors found in Section 28(e). There is a research services safe harbor applying to eligible products and services used by an RIA to perform its investment decision-making responsibilities for discretionary accounts. This safe harbor typically applies to financial publications and research reports.

The second is a brokerage services safe harbor covering eligible products and services used in conjunction with activities required to effect securities transactions, as well as functions incidental to securities transactions and services required by regulatory rules. Communication services relating to the execution, clearing, and settlement of securities transactions would fall within the brokerage services safe harbor.

With both safe harbors, RIAs must act in good faith to determine that the amount of commissions paid is reasonable vis-à-vis the value of the products or services received. If the requirements of Section 28(e) are met, RIAs may accept soft dollars without breaching their fiduciary duties to clients. To rely on Section 28(e), an RIA must make a good faith determination that the amount of commission is reasonable in relation to the value of brokerage and research services provided by the broker-dealer. The SEC believes the burden is greater when an RIA enters into a soft dollar arrangement with an affiliated broker-dealer.

Section 28(e) is not a safe harbor from other anti-fraud provisions of federal and state securities laws. For example, it does not protect an RIA from claims based on fraud arising from churning and misrepresentation.

SEC’s Guidance Relating to Soft Dollars

Because of the SEC’s Interpretive Release, research services are restricted to advice, analyses, or reports within the meaning of Section 28(e)(3). The products or services must be an “expression of reasoning or knowledge.” If they are not, they will not constitute advice, analyses, and reports, and won’t qualify as research services under the safe harbor.

The SEC’s Interpretive Release gives examples of products and services that are an expression of reasoning or knowledge. Physical items, such as computer hardware and accessories, cannot be classified as research services. Telecommunications lines, computer cables, and office equipment are among the other items that are not eligible for soft dollar credits under the research services safe harbor. Although physical items like hardware and T-1 lines assist in the delivery of research, they do not reflect substantive content related to investment decision-making. On the other hand, databases containing market, economic, and financial data, may qualify as research services protected by the safe harbor.

It is not enough that the research services fall within the statutory definition of advice, analyses or reports. A product or service must provide an RIA with “lawful and appropriate assistance” in making investment decisions. Whether a product or service provides “lawful and appropriate assistance” depends primarily on how it is used by the RIA.

Mixed-Use Items

A product or service received by an RIA in exchange for soft dollars may also have non-research uses. This is referred to as a mixed-use item and raises an additional conflict of interest for the RIA. If the product or service is used for purposes that fall within Section 28(e), as well as outside the safe harbor, the RIA must treat the product or service as a mixed-use item.

The SEC’s Interpretive Release reiterates that mixed-use items must be reasonably allocated between eligible and ineligible uses. The allocation decision-making process must document how the RIA determined the reasonableness of commissions in relation to the value of research and brokerage services. The allocation must be made in good faith.

An RIA must memorialize its mixed-use allocation decisions. During a regulatory exam, examiners will review the documentation to determine if the RIA made the required good-faith showing that the allocation was reasonable. RIAs are obliged to create and retain adequate records to justify their allocation of mixed-use items.

Third-Party Research and Commission-Sharing Arrangements

Broker-dealers must be financially responsible for the brokerage and research products and services they provide to RIAs. Furthermore, the broker-dealer must be involved in effecting the trade. The SEC’s 1996 Interpretive Release clarifies that the commission-sharing arrangement must be part of a normal and legitimate correspondent relationship in which each broker-dealer is engaged in activities going beyond the mere receipt of commissions.

At a minimum, the introducing broker-dealer must:

be at risk to the clearing broker-dealer for its customers’ failure to pay;

make and/or maintain required records relating to its customer trades, including blotters and order memoranda;

oversee and respond to customer comments regarding the trading process; and

provide oversight of trades and settlements.

If the broker-dealer effecting the trade is not providing research and brokerage services directly, it must be legally bound to a third-party producer of research or brokerage services to pay for the products and services supplied to an RIA.

Temporal Standard for Brokerage Products and Services

In addition to research services, Section 28(e) of the Exchange Act states explicitly that brokerage products and services fall within the safe harbor if they are required to effectuate securities transactions. This safe harbor also applies to functions incidental to securities transactions, such as settlement, custody, and clearance, as well as services required by SEC or SRO rules.

The Interpretive Release established a “temporal standard” for brokerage services. This standard helps distinguish between brokerage services that fall within the safe harbor and those that fall outside of it. To qualify under the temporal safe harbor, the product or services must relate to the execution of a trade extending from the point at which the RIA communicates with the broker-dealer for the purpose of transmitting an order for execution to the point at which funds or securities are delivered or credited to the advisory account.

As a result of that temporal standard, eligible brokerage services include those that are provided between the time an order is transmitted to a broker-dealer and the time when the transaction is cleared and settled. Products and services must be an integral part of the execution of orders in order to qualify under the temporal standard for brokerage services. For example, trading software used to route orders is viewed as brokerage services, thus making it eligible for the Section 28(e) safe harbor. In contrast, order management systems are not eligible under Section 28(e). Error correction services do not fall within the scope of brokerage services, because they are not related to the initial trade and are separate transactions to correct mistakes made while managing the advisory account.

Interestingly, certain products and services not qualifying under the research services safe harbor may qualify under the brokerage services safe harbor if they are integral to the execution of orders by a broker-dealer. For instance, although computer hardware is not eligible for the research services safe harbor, it may qualify as brokerage services under the temporal standard.

Form ADV Disclosure of Soft Dollar Practices

As part of their fiduciary duty, RIAs must disclose whether they accept soft dollars and consequently, RIAs must disclose in plain English how this impacts the brokerage fees paid by clients. Current clients and prospective clients can find out the RIA’s position regarding soft dollars in the firm’s Form ADV disclosure brochure.

Disclosure of this information allows current clients and prospective clients the understanding that by accepting soft dollars, the RIA has a conflict of interest in recommending a particular broker-dealer. They are also advised that clients might not receive the lowest brokerage fees available.

The disclosure brochure should describe the types of products and services the RIA may receive from broker-dealers. The firm should also disclose that the products and services are not just used for those accounts which generated the commissions. Figure 16-1 is an example of the language used by some RIAs in their soft dollar disclosures:

Figure 16-1. Form ADV Example of Soft Dollar Disclosure Language

“In selecting or recommending a broker-dealer, we will consider the value of research and additional brokerage products and services a broker-dealer has provided or will provide to our clients and our firm. Receipt of these additional brokerage products and services are considered to have been paid for with ‘soft dollars.’ Because such services could be considered to provide a benefit to our firm, we may have a conflict of interest in directing your brokerage business. We could receive benefits by selecting a particular broker-dealer to execute your transactions, and the transaction compensation charged by that broker-dealer might not be the lowest compensation we might otherwise be able to negotiate.

The products and services we receive from broker-dealers will generally be used in servicing all of our clients’ accounts. Our use of these products and services will not be limited to the accounts that paid commissions to the broker-dealer for such products and services. In addition, we may not allocate soft dollar benefits to your accounts proportionately to the soft dollar credits the accounts generate. As part of our fiduciary duties to you, we endeavor at all times to put your interests first. You should be aware that the receipt of economic benefits by our firm is considered to create a conflict of interest.

*Used with permission from National Compliance Services, Inc.

How Soft Dollars Can Be Misused

On September 28, 2011, the SEC charged a San Francisco-area RIA with fraud for lying to clients about how soft dollars were being used. The complaint alleged that the RIA also used fabricated documents in an attempt to cover up the fraud and avoid detection by the Commission.

The SEC’s complaint alleged that the RIA and its principals misappropriated more than $178,000 in soft dollars, and that the firm’s principals misrepresented that they were using the soft dollars to pay for legitimate investment research. According to the complaint, the RIA and the firm’s principals were surreptitiously using the money for office equipment, rent, computer hardware and a relative’s salary. The complaint alleged that principals of the firm instructed a research provider paid with soft dollars to inflate its invoices and kick-back money to the RIA to help pay for a new computer server.

In addition, the SEC charged a principal of the RIA with creating a shell research company to cover up the firm’s improper use of soft dollars. Marc Fagel, director of the SEC’s San Francisco regional office, summarized the Commission’s position about the alleged cover-up:

“We take a particularly dim view of those who compound their fraud on investors by providing false information to our examiners.”

The Big Picture

RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC’s interpretive release suggested that an RIA’s failure to stay within the scope of the Section 28(e) safe harbor may violate the advisor’s fiduciary duty to clients. RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and they do not negatively impact the best execution of clients’ transactions.

Disclosure of soft dollar relationships is made in an RIA’s Form ADV disclosure brochure. Many large broker-dealers, such as Schwab and TD Ameritrade, provide RIAs that use their trading platforms with soft dollar disclosure language. This approach ensures that RIAs make full and complete disclosure of how soft dollars are used by the investment advisor.

An RIA may claim in its advertisements that the firm is completely unbiased, but this may be disputed by an examiner if the RIA accepts soft dollars. In addition, there are RIAs that claim to be fee-only investment advisors. The fact that these firms accept soft dollars might undermine their claim of being fee-only advisory firms.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published by The National Underwriter Company/ALM Media.

An attorney and member of the Pennsylvania bar, Les has handled hundreds of consulting and publishing projects for National Compliance Services, www.ncsonline.com, a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several white papers that analyze compliance issues impacting Registered Investment Advisors (RIAs)‎.